Manufacturing surging, but housing will falter

Slack in economy remains huge, keeping inflation at bay

WASHINGTON (MarketWatch) -- U.S. manufacturing is on a tear, one of the few unambiguous positives in an economy that's still struggling to recover from the deepest downturn in generations.

In some ways, this economic recovery fits the classic mold, as factories are running overtime to restock inventories depleted during the panic and to meet renewed demand for capital equipment and consumer goods. It's a familiar story of the business cycle: Excesses in production lead to excessive cutbacks, sowing the seeds for the eventual recovery.

The missing piece this time, of course, is housing. After most recessions, housing is one of the main engines pulling the economy forward, as lower interest rates spur demand, which must be met by new construction.

Not so this time around. Despite the herculean efforts by the government to put a floor under housing, the sector is still severely out-of-balance.

Data to be released in the coming week should reflect these two economies: The resurgent manufacturing sector and the still-moribund housing market.

The third major theme of the week is inflation, or more accurately, the lack of it. With so many resources still laying idle, inflationary pressures are nonexistent.

Industrial production

"Manufacturing is powering ahead," wrote Aaron Smith, an economist for Moody's Economy.com. "Hiring has come back most strongly in manufacturing, and factory overtime has regained nearly all the ground lost during the recession."

Economists surveyed by MarketWatch are forecasting a 1% increase in industrial production in May. It would be the 10th increase in the past 11 months, following the largest drop in output since just after World War II, more than 60 years ago.

Over the past six months, manufacturing output rose at an 8% annual rate, but remained 11% below the 2007 peak and was still below 1999's level. The recovery has a long way to go.

All the indicators for output flashed green in May. According to the employment report, manufacturing has hired 126,000 workers since the beginning of the year, a sharp contrast to the 911,000 jobs lost in the first five months of 2009. Manufacturing employment is down more than 2 million since the recession began. The recovery has a long way to go.

The manufacturing surveys also signaled strong output growth in May. The Institute for Supply Management's production index read 66.6% in May, and 51% of manufacturing firms said production was higher than the month before, the highest percentage in 51 years.

It's too early to see what the impact on manufacturing will be from the European debt crisis, or the Gulf oil spill. Reduced demand from Europe for U.S. exports is expected. A stronger dollar could hurt U.S. exports to other regions. The Gulf spill isn't likely to have much impact on U.S. industrial output.

Economists will be watching for early signs in the regional manufacturing surveys from the New York Fed and the Philly Fed this week, but typically the reaction to such shocks takes time.

Housing

It's payback time for the home-buyers' tax credit. Through April, housing starts had increased by 17% since December, probably in response to the renewed federal subsidy for buyers. But the credit is now expiring, and economists are predicting a 6% drop in new construction in May to a 630,000 seasonally adjusted annual rate from an 18-month high of 672,000 in April.

"The tax-related burst of activity is over," said Smith of Economy.com.

In April, starts were up 41% from the bottom a year earlier, but were off 70% from the 2006 peak. The recovery has a long way to go.

"Home builders have been careful in managing construction activity," wrote Neil Dutta, Michael Hanson and Gary Bigg, economists for Bank of America's Merrill Lynch. The number of homes under construction fell to a record low in April (data go back to 1970), and the supply of new homes on the market hit a 42-year low.

But builders aren't masters of their destiny. A glut of existing homes sits on the market or hidden in the shadows, bolstered by millions of foreclosures and short sales. "Inventories of unsold existing homes will need to be worked off before we see substantial increases in homebuilding," Smith said.

Inflation

Inflation is not this year's problem, or even next's. "It is not inflation worries that loom large as the key risk factor for American policy makers, but questions about the sustainability of the broader economic recovery," wrote Meny Grauman, an economist for CIBC World Markets.

If the consensus estimate is right, inflation as measured by the consumer price index would decelerate to a 2% increase over the past 12 months. The year-over-year increase in the core rate would remain at 0.9%, the lowest in 44 years. In the past six months, core prices are up just 0.3% annualized.

"With substantial excess capacity and tepid consumer demand, there is plenty of disinflationary pressure in the economy," said economists at Merrill.

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